Learning Objectives

Power Notes Chapter M12 Statement of Cash Flows 1. Purpose of the Statement of Cash Flows 2. Reporting Cash Flows 3. Statement of Cash Flows – The Indirect Method 4. Statement of Cash Flows – The Direct Method 5. Financial Analysis and Interpretation Learning Objectives C12

Power Notes Chapter M12 Statement of Cash Flows Slide # Power Note Topics • 3 • 20 • 31 • 34 • 39 • 62 • Cash Flow Basics • Statement of Cash Flows – Two Methods • Changes in Current Accounts • Statement of Cash Flows – Indirect Method • Statement of Cash Flows – Direct Method • Free Cash Flow Note: To select a topic, type the slide # and press Enter.

Reporting Cash Flows The statement of cash flowsreports a firm’s major cash inflows and outflows for a period. Cash flows are reported by three types of activities. 1. Operating activities – transactions that affect net income. 2. Investing activities – transactions that affect noncurrent assets. 3. Financing activities – transactions that affect equity and debt of the entity.

Cash Flows Increases in Cash Decreases in Cash Cash

Cash Flows Increases in Cash Decreases in Cash Operating (receipts from revenues) Cash

Cash Flows Increases in Cash Decreases in Cash Operating Operating (receipts from revenues) (payments for expenses) Cash

Cash Flows Increases in Cash Decreases in Cash Operating Operating (receipts from revenues) (payments for expenses) Cash Investing (receipts from sales of noncurrent assets)

Cash Flows Increases in Cash Decreases in Cash Operating Operating (receipts from revenues) (payments for expenses) Cash Investing Investing (receipts from sales of noncurrent assets) (payments for aquiring noncurrent assets)

Cash Flows Increases in Cash Decreases in Cash Operating Operating (receipts from revenues) (payments for expenses) Cash Investing Investing (receipts from sales of noncurrent assets) (payments for aquiring noncurrent assets) Financing (receipts from issuing equity and debt securities)

Cash Flows Increases in Cash Decreases in Cash Operating Operating (receipts from revenues) (payments for expenses) Cash Investing Investing (receipts from sales of noncurrent assets) (payments for aquiring noncurrent assets) Financing Financing (receipts from issuing equity and debt securities) (payments for dividends, and redemption of debt securities)

Cash Flows – Operating Activities Typical cash inflows Typical cash outflows What are some of the typical cash inflows from operating activities?

Cash Flows – Operating Activities Typical cash inflows Typical cash outflows Sales of goods and services What are some of the typical cash outflows from operating activities? Interest Revenue Dividend Revenue

Cash Flows – Operating Activities Typical cash inflows Typical cash outflows Sales of goods and services Merchandise purchases Interest Revenue Payments of wages & other expenses Dividend Revenue Tax payments

Cash Flows – Investing Activities Typical cash inflows Typical cash outflows What are some of the typical cash inflows from investing activities?

Cash Flows – Investing Activities Typical cash inflows Typical cash outflows Sales of fixed assets and other long-term investments What are some of the typical cash outflows from investing activities? Sale of marketable securities and investments

Cash Flows – Investing Activities Typical cash inflows Typical cash outflows Sales of fixed assets and other long-term investments Purchase of fixed assets and other long-term investments Sale of marketable securities and investments Purchase of marketable securities and investments

Cash Flows – Financing Activities Typical cash inflows Typical cash outflows What are some of the typical cash inflows from financing activities?

Cash Flows – Financing Activities Typical cash inflows Typical cash outflows Sales (issuance) of stock What are some of the typical cash outflows from financing activities? Sale (issuance) of bonds and other money market debt Borrowing from banks and other lending institutions

Cash Flows – Financing Activities Typical cash inflows Typical cash outflows Sales (issuance) of stock Purchase of treasury stock Sale (issuance) of bonds and other money market debt Repayment and redemption of debt (bonds, notes, other) Borrowing from banks and other lending institutions Payment of cash dividends

Statement of Cash Flows The statement of cash flowsis invaluable in assessing the capacity of a firm to achieve goals such as: 1. Generate cash flow from operations. 2. Maintain and expand operating capacity. 3. Pay dividends. 4. Pay debts, including interest, when due. 5. Generate future profits. The primary attention is the flow of cash rather than net income.

Preparing the Statement of Cash Flows Direct Method Net cash flows from operating activitieswill be the difference between the operating cash receiptsand operating cash payments. Net cash flows from operating activitiesis determined by adjusting the accrual net incomefrom operations to reflect a cash-based net incomefrom operations. Indirect Method

Advantages of Using the Direct Method 1. Reports the sources and uses of operating cash receipts and payments. 2. Is easier to understand for many investors. 3. Recommended by the Financial Accounting Standards Board (FASB). Note: The total amount of net cash flow from operating activities will be the same for both direct and indirect methods. Investing and Financing activities sections will be identical for both methods.

Advantages of Using the Indirect Method 1. Focuses on the differences between net incomeand net cash flowfrom operations. 2. Reveals the relationship between the income statement, the balance sheet, and the statement of cash flows. 3. Less costly to prepare. 4. Must be prepared as a supplemental report even if the direct method is used. 5. 98 percent of companies surveyed use the indirect method.

NetSolutionsStatement of Cash Flows – Direct MethodFor the Month Ended November 30, 2002 Cash flows from operating activities: Cash received from customers $ 7,500 Deduct cash payments for expenses and payment to creditors 4,600 Net cash flow from operating activities $ 2,900 Cash payments for acquiring land (10,000) Cash received as owner’s investment $15,000 Deduct cash withdrawal by owner 2,000 Net cash flow from financing activities 13,000 Net cash flow and ending cash balance $ 5,900 Cash flows from investing activities: Cash flows from financing activities:

NetSolutionsStatement of Cash Flows – Indirect MethodFor the Month Ended November 30, 2002 Cash flows from operating activities: Net income, per income statement $ 3,050 Add increase in accounts payable 400 Deduct increase in supplies (550) Net cash flow from operating activities $ 2,900 Cash payments for acquiring of land (10,000) Cash received as owner’s investment $15,000 Deduct cash withdrawal by owner 2,000 Net cash flow from financing activities 13,000 Net cash flow and ending cash balance $ 5,900 Cash flows from investing activities: Cash flows from financing activities:

NetSolutionsStatement of Cash Flows – Direct MethodFor the Month Ended November 30, 2002 Cash flows from operating activities: Cash received from customers $ 7,500 Deduct cash payments for expenses and payment to creditors 4,600 Net cash flow from operating activities $ 2,900 NetSolutionsStatement of Cash Flows – Indirect MethodFor the Month Ended November 30, 2002 Cash flows from operating activities: Net income, per income statement $ 3,050 Add increase in accounts payable 400 Deduct increase in supplies (550) Net cash flow from operating activities $ 2,900

Cash Relationships and Cash Flows Balance Sheet Cash Liabilities Assets = Liabilities + Stockholders’ Equity Cash + Noncash Assets = Liabilities + Stockholders’ Equity Cash = Liabilities + Stockholders’ Equity – Noncash Assets Noncash Assets Stockholders’ Equity

Cash Relationships and Cash Flows Balance Sheet Cash 1 Liabilities Assets = Liabilities + Stockholders’ Equity Cash + Noncash Assets = Liabilities + Stockholders’ Equity Cash = Liabilities + Stockholders’ Equity – Noncash Assets Noncash Assets 3 Stockholders’ Equity 2 1 2 3 The cash flows are determined by analyzing liabilities, stockholders’ equity, and noncash assets.

Changes in Current Accounts Change Accounts 2003 2002 Debit Credit Trade receivables (net) $74,000 $65,000 Inventories 172,000 180,000 Accounts payable (mdse.) 43,500 46,700 Accrued expenses payable 26,500 24,300 Income taxes payable 7,900 8,400 9,000 8,000 3,200 2,200 500 Determine the debit or credit change of each item above.

Changes in Current Accounts Change Accounts 2003 2002 Debit Credit Trade receivables (net) $74,000 $65,000 Inventories 172,000 180,000 Accounts payable (mdse.) 43,500 46,700 Accrued expenses payable 26,500 24,300 Income taxes payable 7,900 8,400 9,000 8,000 3,200 2,200 500 These debit changesare subtracted from net income in the operating activitiessection of the statement of cash flows. Think of these debits as deductions from net income in arriving at net cash flow from operations.

Changes in Current Accounts Change Accounts 2003 2002 Debit Credit Trade receivables (net) $74,000 $65,000 Inventories 172,000 180,000 Accounts payable (mdse.) 43,500 46,700 Accrued expenses payable 26,500 24,300 Income taxes payable 7,900 8,400 9,000 8,000 3,200 2,200 500 These credit changesare added to net income in the operating activitiessection of the statement of cash flows. Think of these credits as additions to net income in arriving at net cash flow from operations.

Operating Activities – Indirect Method Cash flows from operating activities: Add: Net income, per income statement $108,000 Depreciation $ 7,000 Decrease in inventories 8,000 Increase in accrued expenses 2,200 17,200 $125,200 Increase in accounts receivables $ 9,000 Decrease in accounts payable 3,200 Decrease in income taxes payable 500 Gain on sale of land 12,000 24,700 Net cash flow from operating activities $100,500 Deduct: Start with the accrual basis net income shown on the income statement.

Operating Activities – Indirect Method Cash flows from operating activities: Add: Net income, per income statement $108,000 Depreciation $ 7,000 Decrease in inventories 8,000 Increase in accrued expenses 2,200 17,200 $125,200 Increase in accounts receivables $ 9,000 Decrease in accounts payable 3,200 Decrease in income taxes payable 500 Gain on sale of land 12,000 24,700 Net cash flow from operating activities $100,500 Deduct: Because depreciation expense reduced net income but did not require an outflow of cash, it is added back to net income.

Operating Activities – Indirect Method Cash flows from operating activities: Add: Net income, per income statement $108,000 Depreciation $ 7,000 Decrease in inventories 8,000 Increase in accrued expenses 2,200 17,200 $125,200 Increase in accounts receivables $ 9,000 Decrease in accounts payable 3,200 Decrease in income taxes payable 500 Gain on sale of land 12,000 24,700 Net cash flow from operating activities $100,500 Deduct: These represent credit changesin the current accounts. Think of these credits as additional income from a cash perspective. Why do these represent an increased cash flow?

Operating Activities – Indirect Method Cash flows from operating activities: Add: Net income, per income statement $108,000 Depreciation $ 7,000 Decrease in inventories 8,000 Increase in accrued expenses 2,200 17,200 $125,200 Increase in accounts receivables $ 9,000 Decrease in accounts payable 3,200 Decrease in income taxes payable 500 Gain on sale of land 12,000 24,700 Net cash flow from operating activities $100,500 Deduct: These represent debit changesin the current accounts. Think of these debits as additional expense from a cash perspective. Why do these represent a reduced cash flow?

Operating Activities – Indirect Method Cash flows from operating activities: Add: Net income, per income statement $108,000 Depreciation $ 7,000 Decrease in inventories 8,000 Increase in accrued expenses 2,200 17,200 $125,200 Increase in accounts receivables $ 9,000 Decrease in accounts payable 3,200 Decrease in income taxes payable 500 Gain on sale of land 12,000 24,700 Net cash flow from operating activities $100,500 Deduct: This gain was included in net income but did not represent an operating cash flow. The related cash inflow from the sale is reported in the cash flows from investing activities section.

Changes in Current Accounts Change Accounts 2003 2002 Debit Credit Trade receivables (net) $74,000 $65,000 Inventories 172,000 180,000 Accounts payable (mdse.) 43,500 46,700 Accrued expenses payable 26,500 24,300 Income taxes payable 7,900 8,400 9,000 8,000 3,200 2,200 500 These changes in current accounts were used to prepare the statement of cash flows with the indirect method. They will also be used for the direct methodthat follows.

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 Cost of merchandise sold 790,000 Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 This is an accrual basis income statement. The direct methodof reporting cash flows will essentially convert this to a cash basis statement.

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $960,000 Cost of merchandise sold 580,000 Gross profit $380,000 Operating expenses: Depreciation expense $ 18,000 Other operating expenses 260,000 Total operating expenses 278,000 Income from operations $102,000 Other income: Gain on sale of investments $30,000 Other expense: Interest expense 14,000 16,000 Income before income tax $118,000 Income tax 27,500 Net income $ 90,500 Cash collected from customers Changes Debit Credit Sales 960,000 Receivables 9,000 Cash Note: All income statement account balances are zero at the beginning of a period. Therefore, the balance shown represents the amount of change during the period.

Note: The changes in the current balance sheet accounts are determined by comparing the beginning and ending balances. Receivables increased by $9,000 during the period. Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 Cost of merchandise sold 790,000 Gross profit $390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash collected from customers Changes Debit Credit Sales 1,180,000 Receivables 9,000 Cash 1,171,000

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 Gross profit $390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash collected from customers Changes Debit Credit Sales 1,180,000 Receivables 9,000 Cash 1,171,000 The increase in receivables represents a reduction in cash inflow relative to the accrual revenue reported on the income statement.

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 Gross profit $390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash payments for merchandise Changes Debit Credit Cost of mdse. sold 790,000 Inventories 8,000 Accounts payable 3,200 Cash

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 785,200 Gross profit $390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash payments for merchandise Changes Debit Credit Cost of mdse. sold 790,000 Inventories 8,000 Accounts payable 3,200 Cash 785,200

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 785,200 Gross profit $390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash payments for merchandise Changes Debit Credit Cost of mdse. sold 790,000 Inventories 8,000 Accounts payable 3,200 Cash 785,200 A decrease in inventories (credit change) and an decrease in accounts payable (debit change) have the opposite effects.

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Depreciation Changes Debit Credit Depr. expense 7,000 Accum. depreciation 7,000

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 0 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Depreciation Changes Debit Credit Depr. expense 7,000 Accum. depreciation 7,000 There is no cash flow for depreciation expense.

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 0 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash payments for operating expenses Changes Changes Debit Credit Operating expenses 196,000 Accrued expenses 2,200 Cash

Rundell Inc.Income StatementFor the Year Ended December 31, 2003 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 0 Other operating expenses 196,000 (193,800) Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash payments for operating expenses Changes Changes Debit Credit Operating expenses 196,000 Accrued expenses 2,200 Cash 193,800

Learning Objectives